“We learn from history that we do not learn from history” - Hegel

“Investing is hard work. If you’re having fun investing, you’re not doing it right” - George Soros

When and How Will it End? ~ Sell While They’re Celebrating, and Buy When Everyone is Complaining

Barron’s Randall W. Forsyth reports that a “deadly combination of criteria” is luring investors into the market with its old familiar pattern. He cites economist Dr. John Hussman’s research describing “the basic over-valued, over-bought, over-bullish, rising-yields syndrome.” Is today’s market (2012) displaying all the right conditions that have presaged past plunges? According to Hussman, the crowd may be blissfully ignorant, especially when it comes to over-valuations of popular and over-priced stocks, bonds, or asset classes (gold, etc).

If this year follows the same familiar patterns as past markets, there will be ample time to take profits. Market plunges rarely occur overnight. They fall in long, painful stages over several months. Meanwhile, keep your party hat one, make sure you seatbelt is secured, enjoy the ride, and remember…if you’re having fun investing, you’re not doing it right.

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“We don’t like their sound, and guitar music is on the way out.” – Decca Recording Company rejecting the Beatles, 1962

We don’t like their sound, and guitar music is on the way out

There is no shortage of informed guesses about topics ranging from soybean futures, to the value of the greenback, to the impact of La Niña on next year’s South American sea bass catch. Most recently, Wharton Economics Professor Jeremy Siegel has predicted that the Dow Jones Averages will top 15000 within two years. Logically we’re with the Professor. As a practical matter, we agree with Niels Bohr…

“It’s very difficult to make predictions, especially about the future.” – Niels Bohr, Physicist

Anyone who has been an investor for 10 years or longer will find him- or herself impressed by just how smart, articulate, and persuasive the analysts who predict the future can be. If they weren’t so compelling, they wouldn’t be called on to bestow their opinions and forecasts in the media. Some attract legions of followers, and that makes them even more dangerous, because people believe what they say, and put their money on the line based on the expert’s advice. These informed sources back up their forecasts with facts, statistics and logic, and the analysis is compelling. But the truth is, occasionally they are right and often, they are wrong. Rarely is the information consistently useful for making investment decisions.

Why do they do it? Because we want – maybe even need – them to. We are creatures of habit and comfort. Instinctively, we want security, and to know at all times we are enveloped in the warm embrace of logic and common wisdom. If a financial pundit or authority that we hold in high regard says or writes something, we want to believe that what they are saying is true, and we want guidance from their sage advice. No one wants to be out in the cold on their own, where the chaotic uncertainties of the market loom around us like icy, jagged peaks.

Opinions don’t even need to be clearly expressed, as long as they come from what is widely considered to be a legitimate, authoritative source.

Predictions Can Prove Perilous

As surprising as it may seem, many analysts wait for a stock to go down before downgrading it, and for it to go up before they issue a “buy” alert. They wait for confirmation, which is too late to do investors any good. The analysts are using information that is already reflected in the stock price to make their forecasts.

Some ratings changes are timely, but they are usually late, or off the mark. Generally, it’s not a good idea to base your buying or selling decisions on analysts’ recommendations.

Tom Bulkowski, author of “Encyclopedia of Chart Patterns”, found in his research that in a bull market, only 25 percent of downgrades occurred within a third of the stock’s yearly high, when they would do the most good. In a bear market, the forecasts were even worse, with only 13 percent near the yearly high, meaning 87 percent had already gone down when the analyst shouted “sell”.

Here’s where solid probability analysis can be helpful, based on Bulkowski’s research: Tom advises bargain hunters that if a stock’s price declines after an analyst’s downgrade, wait a week or two, when prices usually begin to recover. Wait for the last flurry of selling, and then do your buying.

When analysts prepare their stock forecasts, they look not only at the performance of the company in question, but at the industry in which the company operates. A forecast for a software company, for example, would take into account the world demand for software, and trends affecting the software industry, such as a need by companies to upgrade their information technology capabilities due to competitive pressures or technological advances.

Unfortunately, anticipated industry trends don’t always pan out, and investors who rely too heavily on such forecasts can be left holding the bag. Best to stay with the educated, unemotional approach we advocate for finding Fallen Angels when they’re on sale.

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“Many an optimist has become rich simply by buying out a pessimist” – Laurence J. Peter

Baby Boomer’s Kids are Slowly Taking Over

There are over 90 million of them. Their sheer size has made it difficult to find the jobs they want and need. Reminiscent of their parents in the 1960’s, they’re angry, disenchanted, and intend to “occupy” Wall Street, main street, and those other places they’ll eventually be running. The largest generation in U.S. history will be coming of age during this decade. To successfully play this big picture bet, you’ll want to own industries and service providers they will need to raise families, build a secure future, and “live the dream.”

Baby Boomers are Slowly Retiring

79 million Americans are nearing retirement age. A growing majority have decided to stay in their jobs and professions until they can more comfortably retire. The unexpected consequence for their adult children has been a tighter job market…for now. Many baby boomers are trying to stay youthful through medical intervention, diet, and exercise. They’ve taken Dylan Thomas’s poetic advice, “Do not go gentle into that good night.” This mega-trend is having a major impact on the health care and bio-tech industries. Travel and financial services should prosper, too.

Population & Demographic Shifts ~ India’s Growing Middle Class ~ Russia’s Declining Population

India’s middle class of over 300 million is larger than the entire U.S. population, and it’s growing. With 1.2 billion people, India’s swelling prosperity is causing increasing demand for houses, cars, appliances, technology, and discretionary goods. The Indian stock market has sold off sharply, and we expect higher markets over the long term.

Russia’s population is slowly declining due to low birth rates, high mortality, and the growing desire to find greener pastures elsewhere. With only 149 million people, any population decline would mean reduced revenue for a wide range of companies located there. The “R” in BRIC emerging markets may create a drag for that now famous investment theme. Just in time, along comes a new ETF that replaces Russia with South Korea. Comprised of stocks from “B” Brazil, “I” India, “C” China, and “K” Korea, it’s called “The First Trust BICK Index Fund” (symbol BICK). BICK appears to be a Fallen Angel.

Natural Gas Demand Will Grow

At 20 year lows, the Natural gas bear market looks a lot like another well known bear market which lasted 20 years. After two down-trending decades, gold prices finally stopped falling in 1999. Gold eventually bottomed near $250 an ounce before slowly turning around. Natural gas use in the U.S. and emerging markets is almost certain to grow because it’s cheap, clean, and abundant. Major players include Conoco Phillips (COP), Exxon Mobil (XON), Nobel Energy (NBL), BP Petroleum, and a number of smaller energy concerns. BP estimates that Chinese demand will grow at an annual rate of over 7%, and natural gas will likely be the fastest growing fossil fuel globally for years to come.

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“Confidence is a fragile thing.” – Joe Montana

Makes Your Eyes Glaze Over

Here are the common characteristics to every great contrarian investment opportunity.

1. Interest in the asset class or company has completely petered out. 10 years ago ~ Remember Gold, Steel, Copper, or energy. Prices were five to ten times lower then and no one was interested.
2. If the topic comes up, it makes your eyes glaze over. Today ~ Think about Japanese stocks, bank stocks, and blue chip stocks for the long run. Prices have fallen, yet revenues doubled or tripled over the past 10 years.
3. A declining Dollar buys less and less, but the contrarian investment becomes worth more and more. Tomorrow ~ compounding shareholder’s equity at 10% per year gives you twice as much equity (book value) in seven years.

Logic suggests following these three simple guidelines should lead us to the new 5 and 10 baggers of this decade. So what gets in the way? Why are so few people able to buy low when no one is interested, be patient, and then sell high when everyone is willing to over pay? Investors have trouble making rational decisions when real money is at stake. Psychological stress impairs logic, distorts our reasoning, and keeps us from buying true bargains. No one wanted gold in 1999 at $260 an ounce, not even the Bank of England, so they sold it all. Brett Arends of the Wall Street Journal / Smart Money reported that at least “one analyst at the time thought gold was headed for $100. It proved, in retrospect, the bargain of our lifetimes, but no one was interested.”

10 years ago, no one wanted railroad stocks, oil companies, commodities. Since then, many of these investments have quadrupled. So, what’s on sale now? You won’t want to miss the great contrarian opportunities available today. We’ve prepared a rational guide that can help remove negative emotions and put you in a position to hopefully make some meaningful money.

The Pilot’s Check-List for Safe & Effective Investing

Every good pilot knows that a thorough check of his or her aircraft is essential before lift-off. Once the airplane is airborne, there’s no place to pull over if a mechanical problem comes up and so pilots want to make sure nothing is wrong before they leave the ground. High in the sky is no place to find out a magneto is bad, a rudder is sticking or an engine isn’t firing properly.

And the same holds true for investing. You don’t want to be stuck with AIG down 96% from $30, Citigroup down 95% from $40 or G.E down 60% from $35. Holding on and hoping for investment survival is not where you want to be.

Using an investment checklist can give you a set of benchmarks for evaluating investments before you actually take the plunge. Like a good pilot, you should follow this checklist every time you invest to make sure that your potential investment has the wings and propulsion necessary to take flight.

Pick up your copy of “Wisdom on Value Investing: How to Profit on Fallen Angels” for more on the investing checklist we use at American Money Management LLC.

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“Now is always the most difficult time to invest” – Anonymous

“The question of when to buy is far more important than what to buy” – Roger Babson

These two concepts contradict themselves, yet they’re both accurate and worthwhile quotations. Perhaps it’s because eventually, “any successful approach to investing is bound to fail” (Wilson’s Rule, Robert Wilson). Successful approaches fail when too many people start following them, and we’ve also seen them fail when governments or markets do. Wouldn’t it be nice if every complicated problem could be solved with a simple solution, but it just isn’t so.

A real anomaly is one that can be profitably exploited by investors to earn statistically reliable and positive risk-adjusted returns. – Professor Mozaffar Khan, MIT Sloan School of Management

There are some investment “anomalies” which occur with enough frequency that you should learn what they are and how they affect markets. I spoke recently with Leonard Zacks, founder and CEO of Zacks Investment Research in Chicago about his life long obsession with exploiting predictable investor behavior (www.zacks.com). Leonard recently created and edited “The Handbook of Equity Market Anomalies, Translating Market Inefficiencies into Effective Investment Strategies”, recently published by Wiley. Since 2000, the number of anomaly related academic papers has grown so quickly that it is “now almost impossible for any one person to keep up with the full scope for this research.” Leonard called upon his many friends from leading academic institutions to help create a single volume that summarizes the various exploitable anomalies which repeat with enough frequency to be potentially profitable.

Earnings Revision Anomaly ~ Why Investors Drag Their Feet

The “earnings revision anomaly” is a favorite of Leonard Zacks. Here’s why. Brokerage firm analysts try to forecast future earnings of the stocks they cover. The complex valuation models they create are intended to help them predict future share prices based on a company’s expected earnings. As the companies they follow report on day to day business conditions, these models get frequently adjusted and tweaked. Therefore, the most frequently repeated activity of analysts is their earnings forecast reports, and consequently, revisions of earlier earnings forecasts, either up or down.

Zacks researchers found that professional investors who manage large pensions and mutual funds are especially reluctant to make buying decisions based on these commonly occurring reports from Wall Street. Like the rest of us, they’re skeptical of new information intended to persuade us toward purchasing any investment. So naturally, when a brokerage analyst revises earnings upward, there’s a delayed response before any major buying occurs. Note that this is completely opposite investor behavior from when earnings are revised downward, and everyone rushes, sometimes in a panic, to “sell first, and ask questions later.”

But when the news is good, and earnings are rising faster than analysts had expected, professional investors drag their feet. They call meetings and delay making purchase decisions until getting comfortable, often well after the price has begun rising. This predictable response creates one of the most commonly occurring anomalies that you’re likely to encounter. It presents opportunities for individual investors who can take immediate action before others do. Like the Oracle says, “If I want a second opinion, I look in the mirror.” Consider reading The Handbook of Equity Market Anomalies, and pay particular attention to whenever earnings are revised upward!!

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When you own shares in a company, its underlying business fundamentals are far more important than its current quoted stock price. You want to own companies that are going to be more valuable and larger in the future. If the company is growing by 15 to 20 percent each year, you don’t have to stress out if the share price is temporarily depressed. In fact, you might be confronting a wonderful opportunity to acquire more shares of a great company at a discount.

Web sites such as Yahoo! Finance and services like Value Line and Investors Business Daily offer information about thousands of publicly traded companies, including historical information about performance, growth, earnings, debt and other indicators of a company’s financial health.

From Blue Chips to Cow Chips

People who owned those ill-fated companies may have to wait years just to break even on their investments, or they may never recoup their losses. If you have already ridden well known corporate giants down, now is the time to examine their financial data to determine if they possess the necessary ingredients for a comeback. If not, sell, take your losses and invest in some up-and-comers. While it eases the pain to take losses for tax purposes, it’s not something to do often, as no one ever got rich that way.

This year, over half of the 500 companies that make up the S&P 500 have either initiated a dividend, or have raised dividends. Once they begin paying shareholders, or providing a pay raise, it’s very difficult to stop. To help find Cow Chips turning to Blue Chips, find the new or aggressive dividend payers.

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“A very good bit of advice: If you are a retail investor, don’t check the value of your portfolio too often.” -Jack Scanell, Sanford C. Bernstein Ltd.

Volatility and the Risk of Heart Attack

The connection between falling markets and sudden cardiac arrest appears to be international. Another study just released showed that even a 5 percent move in the Shanghai Composite Index increased heart attack risks among Shanghai residents by about 17 percent. Heart attack deaths in Shanghai correlated with the size of daily swings, so a 20 percent correction might be enough to trigger a national pandemic.

Magic Formula ~ Buy When Everyone is Complaining, and Sell When They’re Celebrating

There’s no better way to prosper from the Fallen Angels methodology than to remember this magic formula. Train your brain to get happy whenever markets tumble. Practice on paper before committing real money. Make a list of securities you pretend to have purchased each time Mr. Market goes into panic mode, and keep track of your performance. This is a popular technique used by many of the world’s greatest investors, who keep a “trading diary.” Master this simple technique and you’ll get wealthy and stay healthy.

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“Flying is the second greatest thrill known to man…Landing is the first”
Old Aviator’s Adage

Here are the numbers: There have been 10 Bear Markets and 10 Bull Markets over the last 65 years. Research from Standard and Poor’s Index Services concludes that Bull Markets are more powerful and last almost four times longer than Bear Markets.

Since 1949, the past 10 Bull Markets produced an average total return of 149%, and lasted around 58 months.
Since 1946, Bear Markets had an average duration of 16 months with an average cumulative loss of 32%.

Your odds for appreciation have been almost four times better. The million (or billion) dollar question is: Can you remain calm enough during the downturns to stay on board. Look at a chart of the Dow Jones Averages over the past 90 years, and you see a rising mountain with no apparent end in sight. Segment the same chart into shorter 10 year periods and the picture tells quite a different story. Over every 10 year span, the chart reveals multi-year periods of volatility, punctuated with turbulent advances and declines. Even so, the majority of decades provided attractive total returns sufficient to reward shareholders for the wild ride. As the old aviator’s adage says, “flying is only the second greatest thrill…landing is first.” Humans are terrestrial, so we’re more secure with feet firmly planted on the ground. To succeed as an investor requires training, much like a pilot who learns through practice to feel comfortable in the air.

Happy Birthday! 10,000 Boomers Turned 60 Today

There are 72 million of them, so this trend continues for another 10 years. After age 60, most people begin slowing down, needing income oriented investments to help fund retirement. Increasing demand for bonds could keep interest rates low for at least another decade. Here’s the good news: Those boomers produced millions of children, and now the largest young generation in history is just beginning to come of age. Several years from now, 91 million Gen Y members enter the work force; buying homes, and all the other stuff that goes with family life. Prepare for what may turn out to be the biggest economic boom of your lifetime. Accumulate Fallen Angels while markets remain depressed.

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“Knowledge of financial history is critical to successful investing”
-“The Successful Investor Today” by Larry Swedroe (2003)

Since 1946, there have been 12 bear markets (declines of 20% or more). On average, it has taken 9 months for the S&P 500 to fall 20%. According to S&P Chief Equity Strategist Sam Stoval, if the current decline were to become another bear market (number 13) and follow the historical pattern, the S&P 500 will cross the 20% decline threshold by January 2012 (closing below 1091) and ultimately bottom in the low-900s by mid-2012 (WSJ.com’s inside look at the markets). Before you sell all your stocks based on this bit of data or, more commonly, because markets have performed so badly over the last year, read on.

Warning ~ Do Not Attempt Forecasting The Market by Extrapolating From The Past

It’s far easier to lose money than to make it, and one of the major contributing factors has to be “hindsight bias.” We assume (incorrectly) that past performance provides insight into future results, and history proves the opposite to be true. Past performance does NOT suggest future results. Chasing performance by getting into investments that have done well is just as risky as attempting to time the market, or attempting to guess where the low may occur. Remember Jesse Livermore’s counsel from over 80 years ago. “Markets are never wrong – opinions are.”

Where are the Investor’s Yachts?

Over a 20 year time span (1991 – 2010) the S&P 500 annualized at 7.7%, providing investors with a very nice return. Even more impressive, 7.7% includes the “lost decade” where stocks did not perform well from 2000 – 2010. So, how did the Average Investor make out over that same 20 year period? According to research from Dalbar and J.P.Morgan Asset Management, the Average Investor generated only 2.6% annualized, which is well below average when compared with 7.7%. What went wrong? Our hunch is investors sold after big declines, and then bought back into the market after watching large advances. In other words, the Average Investor (many professionals, too) assumed that past events, both positive and negative, provided some indication of future results.

Best Performing Asset Class Over 20 Years? It’s a Surprise!

Another surprise from the Dalbar Research study: Over that same 20 year period, the highest annualized returns of all asset classes did not come from Oil, Stocks, Gold, or Foreign Markets. Publicly-traded Real Estate Investment Trusts (REITS) provided the best returns, annualizing at 10.5%. Very impressive performance, especially when you consider that 1991 – 2010 includes two of the worst real estate busts in modern history. Perhaps the great results can be attributed to dividends and distributions. While it might seem logical to conclude that residential real estate (your home) did as well or better than REITS over this same timeframe, Dalbar reports that Homes were the single worst asset class among the eight they followed. In last place, Homes generated a 2.8% annualized return! Conclusion: Watch your biases, and use these depressed markets to acquire great investments while they’re cheap, and perhaps getting cheaper.

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While providing market commentary for CBS Los Angeles Radio affiliates KFWB and KNX, show host Bob McCormick asked me why anyone would ever buy stocks. The last 10 years have presented significant risks, and for many investors, very little if any return, so why should anyone even bother with the stock market. Bob’s question echoes the sentiments of a growing number of Americans, as evidenced by trillions of investment dollars sidelined in money markets, CD’s, and short term bonds. Here’s my answer, based on investor behavior patterns over the past 80 years.

“Markets never change because people never change”
Jesse Livermore, early twentieth-century trader

For many years, people held onto shares of dividend paying stocks, and rarely considered selling them so long as dividends were paid. Additionally, companies rewarded loyal shareholders by increasing dividend payouts each year. We’ve all heard the stories about people who owned dependable dividend paying stocks purchased in the 1940’s or 50’s where a few thousand dollars turned into a money machine generating many times more in dividends each year than the original amount of an investor’s early purchases.

But in 1986 a massive shift away from dividend stocks began with the passing of a tax reform act, which provided lower tax rates on capital gains. Taxes on dividends remained high compared with the more favorable rates placed on shares, if held long term (12 months). Public companies responded to these new tax incentives by placing greater importance on increasing book value or shareholders equity, while de-emphasizing dividends or other distributions of cash. The justification was a simple one. Growing companies should be able generate higher returns on their excess cash than their shareholders could, by investing in expansion or acquisitions. Paying that capital out to shareholders limited the options for expansion.

It worked and rising book values led to rising stocks, and rising markets. Now 25 years later, the largest generation in American history is nearing retirement age, creating a new significant shift; a massive sea change where investors are moving away from stocks that offer growth potential because they can’t tolerate as much downside risk as when they were younger. For retirees, dividends and cash flow have far more appeal. Attempting to buy low, then hoping to sell high is less desirable than it once was. Additionally, these days dividends are given preferential tax treatment over short-term capital gains, so public companies are again responding by placing greater importance on increasing dividend payouts to attract loyal long-term shareholders.

REINVESTED DIVIDEND INCOME PRODUCED OVER 90 PERCENT OF S&P 500 RETURNS SINCE 1926

John Bogle’s famous study which includes the pre-1957 S&P 90 found that $10,000 with all dividends reinvested beginning in 1926 would have grown to $33,100,000 by September 2007. If dividends had not been reinvested, the original $10,000 invested in 1926 would have grown to about 1.2 million, an absolutely amazing gap of $32 million dollars!! So why should anyone even bother with the stock market in 2011? Because you will want and need the dividend income that major companies have proven to generate over time.

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